State Street Vision Focus: Regulatory Change

Originally published in the June 2011 issue

The financial crisis has triggered a series of regulatory initiatives that are set to influence the competitive landscape for European asset managers. While pre-crisis regulation focused largely on market efficiency, many of the new measures are focused on issues of investor protection. The pace and rigour of these developments may increase complexity and cost, with potential implications for the way in which asset managers structure their businesses and plan their strategy. New regulation will create both challenges and opportunities for Europe’s investment management industry, and redefine the criteria for success.

While the European financial services sector has faced significant regulatory change over the past decade, the pace of change has accelerated rapidly in the wake of the financial crisis. The events of the crisis, including the collapse of Lehman Brothers and the Bernard Madoff fraud, have triggered a wave of new regulation worldwide that is set to have a significant impact on business practices and operating models.

Regulation of vulnerabilities
Before the crisis, regulators were largely focused on enhancing market efficiency, through initiatives such as the Markets in Financial Instruments Directive (MiFID) and the evolving framework for Undertakings for Collective Investment in Transferable Securities (UCITS). In the wake of the crisis, however, the focus of regulatory efforts has shifted. Today, the emphasis is firmly on addressing systemic vulnerabilities, improving market transparency and enhancing investor protection. Asset managers are increasingly the focus of regulatory reform, through initiatives such as the Alternative Investment Fund Managers Directive (AIFMD) and UCITS V.

A raft of new regulation is in the pipeline. Basel III and Solvency II are set to address capital adequacy and risk management in the banking and insurance sectors. The AIFMD and the European Market Infrastructures Regulation (EMIR) will introduce new regimes for alternative funds and over-the-counter (OTC) derivatives, respectively.

Several regulatory initiatives, including the MiFID II review, UCITS V, the European Commission’s initiative on Packaged Retail Investment Products (PRIPs), and the review of the Investor Compensation Scheme Directive (ICSD), have implications for the market in retail investment products. Meanwhile, depositaries and custodians are subject to changes in their responsibilities and legal liability, although the exact framework will depend on the final outcome of the legislative and rule-making process. Regulators also have remuneration in their sights, with efforts towards more clearly aligning the compensation of individuals in key risk-taking and supervisory roles with the long-term performance of their businesses, across the financial industry.

Challenges for asset managers
While increasing investor protection and enhancing risk management practices are important goals, these measures are also likely to increase complexity in terms of reporting and cost. They are also likely to have a fundamental impact on how investment products are marketed and sold. Asset managers may need to undertake a root-and-branch assessment of their current approach, extending from their operating model to their product range and target investors.

These changes are happening against the backdrop of broader, secular pressures on the industry. The “pension gap” is becoming an increasingly acute problem. With an ageing demographic, and the shift from defined benefit (DB) to defined contribution (DC) pension schemes, individuals are having to bear more of the investment risk of funding their extended retirements. Solid investment returns will become more critical than ever to plug the gap. There are many outstanding questions: will outperformance be harder to achieve amid increased regulatory complexity and cost — against a backdrop of only moderate economic growth expectations? How can asset managers square this dilemma? Does this environment create opportunities for asset managers that are agile and innovative in the face of major regulatory developments?

What is certain is that the industry will experience significant evolution, at least in the short to medium term, amid continued and rapid regulatory change. This article examines the shift in regulatory emphasis post-crisis and highlights some of the key regulatory initiatives that will impact European asset managers. Drawing on our years of working closely with clients in Europe, and our efforts in shaping the regulatory framework in the region, this article gauges the impact on the competitive environment for asset managers and identifies the qualities needed to succeed.

A shifting regulatory landscape
Although there are myriad regulatory initiatives at different stages of development within Europe, each addressing a specific area or issue within banking or asset management, they are focused around a small number of guiding themes and priorities. Investor protection is certainly one of these themes, and has taken on greater importance post-crisis.

The evolution in regulatory thinking is underscored by examining the journey from UCITS IV to UCITS V. UCITS IV is the final pre-crisis regulatory initiative to be enacted, and is set to come into effect in July 2011, which is the deadline for all 27 European Union member states to implement its measures at a national level. While primarily focused on achieving greater market efficiency by enabling fund mergers and master-feeder structures across EU member states, the directive also has an investor protection element. Under UCITS IV, asset managers are required to publish a Key Investor Information Document (KIID) for each fund. This two-page fact sheet (or three pages in the case of structured UCITS) replaces the simplified prospectus, and is designed to make it easier for investors to understand and compare fund products.

The principal aim of UCITS IV is to improve the efficiency of European investment funds by overcoming national barriers and promoting economies of scale. How successfully the directive can achieve this goal will depend on a number of factors, and any progress will certainly take some time — the industry will not be transformed overnight. Indeed, local implementation of UCITS IV may serve to highlight the difficulties in achieving the holy grail of a pan-European market in investment products, given the continuing obstacles — particularly around the lack of tax harmonisation — across member states.

UCITS IV is only the latest iteration of the UCITS framework, which has grown into a globally recognised and respected brand since the original UCITS directive in 1985. The framework has evolved over the years, in line with asset managers’ expanding needs. For example, since the introduction of UCITS III, which allowed funds to invest in financial derivatives, hedge funds have seized the opportunity to market alternative-style investment strategies under the UCITS brand — thereby driving the so-called “Newcits” trend.

Moving to UCITS V
The evolution of UCITS is set to continue with the advent of UCITS V, which has been designed with the lessons of the financial crisis, including the Lehman Brothers collapse and the Madoff scandal, firmly in mind. The speed with which UCITS V is set to follow the implementation of UCITS IV underscores the accelerated pace of regulatory change. It also highlights the shift of focus from market efficiency to investor protection, given that UCITS V is targeted at issues such as clarifying the roles and responsibilities of depositaries and establishing a governance structure for asset managers’ remuneration. With regard to remuneration, the key principle of UCITS V is to ensure consistency with the regimes in place for other financial markets participants. Guidance from the Committee of European Banking Supervisors, now the European Banking Authority, has already addressed remuneration practices in Europe’s banks. UCITS V and the AIFMD are likely to crystallise these recommendations in the asset management industry.

Importantly, UCITS V draws on the AIFMD (see below), with proposals to similarly redefine depositary liability. The approach taken by UCITS V will potentially have implications for fund managers of all sizes, including what functions they may want to delegate to third-party service providers, the nature of their continuing responsibilities to the investor, and the extent of the liabilities to be assumed by depositaries and custodians.

The answers to these questions will have a direct effect on how UCITS fund managers configure and control their operating model, and possibly even on how they shape their investment strategies. There is the issue of where the added cost to asset managers of regulatory compliance will fall within the investment value chain — and whether it will spur further efforts to streamline operating models in order to improve efficiency. Even so, it is important that the envisioned harmonised framework carefully balances the crucial goal of heightened investor protection with the imperatives of legal certainty, cost efficiency and the avoidance of systemic risk.

AIFMD: indicates intent
The exact shape of UCITS V is difficult to accurately predict while it is still being formulated, but the AIFMD provides some indication of its general intent. The EC approved the AIFMD in November 2010, with the directive due to come into force in the first half of 2013. The Level 2 discussion process, involving the European Commission and the European Securities and Markets Authority (ESMA), formerly the Committee of European Securities Regulators (CESR), will determine the exact details of how AIFMD will operate.

Hedge funds, private equity and real estate are among the players to fall within the scope of the AIFMD, which in general applies to managers of non-UCITS funds. The directive will cover all asset managers based, or seeking to distribute investment funds, across Europe.The directive creates significant potential benefits for alternatives managers by introducing a European passport that will make it easier to distribute their investment products across the region, but this comes at the expense of increased reporting needs and supervisory oversight. The directive also imposes capital requirements that will cover all but the smallest, independent firms.

There is scope for local regulators to flex the AIFMD as they see fit within their respective jurisdictions. Although the directive is primarily aimed at safeguarding the interests of professional investors, individual authorities may decide to extend their authorisation to allow the sale of alternative funds to retail investors under the auspices of AIFMD. While the regulatory goals are clear, the costs entailed are, at this stage, difficult to quantify. Operationally, alternative managers may not have the in-house expertise and headcount needed to meet the directive’s requirements. Where service providers, including depositaries, are required to take on additional responsibilities, they will be focused on reducing risks in the cross-border investment process for clients.

Areas of significant impact
While serving to establish a harmonised framework in the alternatives space, the AIFMD may have a significant impact on asset managers in terms of compliance and cost, stemming from a variety of operational requirements that include the following:

• Every alternative fund must have a manager authorised by its home member state
• Funds must be valued, at least annually, by a legally or at least functionally independent valuer
• Funds are required to have an independent depositary
• The directive sets out extensive and rigorous obligations for reporting to regulators and increased levels of disclosure to investors both before they invest and annually once they are invested
• Although the detail is being discussed, custodians and depositaries are set to assume increased levels of responsibility and liability
• The directive will cover reward and remuneration structures, linking compensation for longer term performance to the degree of risk-taking responsibility of individual key employees
• Significant constraints on private equity funds prevent them from cashing in their invest¬ments within 24 months to prevent asset stripping

While the obvious conclusion is that any additional costs will be met from investor returns, the effect of the AIFMD and other emerging regulation is likely to be more complex. As we explore in Chapter II, the shape and pace of regulatory change in Europe is set to have fundamental structural implications for the business environment for asset managers. Levels of competition and innovation are likely to step up a gear.

The recent flurry of consolidation in the industry could persist, as managers pursue scale to absorb increased costs and support additional reporting needs. Others may decide that by staying small they can be more agile in a rapidly changing environment. What is certain is that, amid the wealth of emerging regulation, there will be winners and losers, and their identity will determine the future shape of the European investment management industry.

The winners and the losers
The depth and duration of the financial crisis have left a lingering impression on investors’ attitudes toward risk and, in some cases, undermined their trust in financial markets. Tightening regulation is an important factor in restoring that trust. For asset managers, there is competitive advantage to be gained by responding quickly, comprehensively and inventively to the emerging regulatory environment. Early movers in understanding and adapting to new regulation, and in demonstrating to clients their efforts, may prove to be the winners.

The speed of change is a particular challenge, even for those individuals whose job it is to monitor regulatory developments. Successful firms will be keen to demonstrate to existing and potential clients that they are knowledgeable about, and ready to adopt, the full range of forthcoming initiatives as they are introduced in the coming months and years.

While we have already noted above some of the costs and complexities that initiatives such as the AIFMD may create, these are not the only challenges that asset managers may experience. As banking regulation begins to exert a greater influence on the asset management industry, managers may face regulatory frameworks that do not always take sufficient account of the specific needs and characteristics of their sector.

This article is the second in a series of three Vision Focus papers on European investment management. The first paper, published in October 2010, examined the key structural changes in the industry post-crisis, while a third paper will examine how the changing needs of investors are redefining the investment proposition. The full paper is available on line at